# L4_PPP - Last Class Foreign exchange markets Products spot...

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Last Class Foreign exchange markets ± Products: spot, forward and swap ± Activities: speculation and arbitrage ± Empirical facts: size, trading styles, etc. Outline of this class ² Relationship between forward and spot contracts ² International parity condition 1: PPP Sources: Levich, Chapter 4 ± Absolute PPP theory (LOP) ± Relative PPP theory ± Empirical facts

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Perfect Capital Markets Assumptions: 1. No transactions costs 2. No taxes 3. No uncertainty * We derive all the parity conditions under perfect capital markets. Four Parity Conditions Arbitrage in goods market Purchasing Power Parity Arbitrage in money market Interest Rate Parity Arbitrage between real and nominal assets Fisher Parity conditions Arbitrage in exchange markets Forward rate unbiased condition
Purchasing Power Parity (PPP) ± Spatial arbitrage in goods markets gives rise to the Law of One Price (LOP). ± The Law of One Price: identical goods should sell for the same price in two markets, taking into account the exchange rate in a PCM. P US,corn = S \$/€ * P Germany,corn Absolute PPP ± If the LOP holds for each good, then it should hold for an aggregate bundle of goods. P US = S \$/€ P Ger where, P US = Σ W US,i P US,i P Ger = Σ W Ger,i P Ger,i ± Another implicit assumption: consumption baskets are identical across countries.

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Example 1: Suppose you have the following information about consumer spending: US (\$) Germany (€) weight price weight price Auto 0.15 20,000 0.15 40,000 Home 0.50 175,000 0.50 350,000 Food 0.35 5,000 0.35 10,000 S \$/€ = 0.5 Q: Does the Law of One Price hold? Q: Does Absolute PPP hold? US (\$) Germany (€) weight price weight price Auto 0.15 20,000 0.15 40,000 Home 0.50 175,000 0.50 350,000 Food 0.35 5,000 0.35 10,000 1. The LOP holds for each good. 2. Check absolute PPP: In the US: P US = (0.15)(20,000) + (0.50)(175,000)+(0.35)(5,000) = 92,250\$ P Ger = (0.15)(40,000) + (0.50)(350,000)+(0.35)(10,000) = 184,500€ 184,500 € *(0.5)\$/€ = 92,250\$ Thus, Absolute PPP holds.
Example 2: Suppose you have the following information about consumer spending: US (\$) Germany (€) weight price weight price Auto 0.15 20,000 0.20 40,000 Home 0.50 175,000 0.45 350,000 Food 0.35 5,000 0.35 10,000 S \$/€ = 0.5 Q: Does the Law of One Price hold? Q: Does Absolute PPP hold? US (\$) Germany (€) weight price weight price Auto 0.15 20,000 0.20 40,000 Home 0.50 175,000 0.45 350,000 Food 0.35 5,000 0.35 10,000 1. The LOP holds clearly. 2. Check on absolute PPP: P US = (0.15)(20,000) + (0.50)(175,000)+(0.35)(5,000) = 92,250\$ P Ger = (0.20)(40,000) + (0.45)(350,000)+(0.35)(10,000) = 169,000€ 169,000 € *(0.5) \$/€= 84,500\$ 92,250\$ Thus, absolute PPP doesn’t hold.

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Example 3: Suppose you have the following information about consumer spending: US (\$) Germany (euro) weight price weight price Auto 0.15 20,000 0.20 40,000 Home 0.50 175,000 0.45 380,000 Food 0.35 5,000 0.35 10,000 S \$/euro = 0.5 Q: Does the Law of One Price hold? Q:
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L4_PPP - Last Class Foreign exchange markets Products spot...

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